Factor investing took the ETF world by storm during the last few years. Countless factor—also referred to as “smart-beta”—ETFs were launched, giving investors the chance to outperform the broader stock market.
This year, the enthusiasm for these products has died down a bit, perhaps because they aren’t as new or exciting as they were before. Still, factor ETFs aren’t going away anytime soon; if anything, they’ve made the transition from just a hot trend to a mainstay in many investors’ portfolios.
What Are Factors?
According to MSCI, factors are any stock characteristics “that can be shown to be important … in explaining risk or returns.”
There could be thousands of factors, but most do not outperform the market over the long term. Historically, value and growth were the two factors that investors focused on. More recently, factors like low volatility, momentum and others have shown potential to outperform in certain market environments.
Here we’ll run down the best-performing factor ETFs this year, focusing only on the funds that offer broad exposure to U.S. equities.
Factor Of The Year
A quick glance at our list reveals that growth is the factor of the year. ETFs that target growth stocks—whether it be within large-cap, midcap or small-cap stocks—are all up 10% or more.
Top Performing Factor ETFs Of 2018
There are many ways ETFs and their underlying indexes attempt to target a particular factor, which can lead to significantly different returns among various funds targeting the same factor. But these three funds all track the same S&P 500 growth index—which selects growth stocks based on sales growth, earnings growth and momentum—leading to nearly identical performance.
Pure Growth ETFs
SPYG, VOOG and IVW are traditional growth ETFs that don’t stray too far from the broader market. With 299 holdings in their portfolio, each fund holds more than half of the 505 stocks that comprise the S&P 500.
For investors wanting modest exposure to the growth factor without risk of deviating too far from the market return, those types of ETFs are good options.
For investors wanting more potent exposure to the growth factor, “pure” growth ETFs are available. The Invesco Russell Midcap Pure Growth ETF (PXMG), with a 16.1% year-to-date gain, is one such fund.
It tracks the Russell Midcap Pure Growth Index, which narrows the universe of growth stocks further than a traditional growth index. Pure growth indices are more aggressive than their traditional counterparts, offering exposure to a smaller basket of stocks with the strongest growth characteristics.
The more targeted exposure results in a more concentrated portfolio for PXMG—96 holdings—compared with the 800 stocks comprising the broader Russell Midcap Index, or even the 415 stocks in the Russell Midcap Growth Index.
Not For All
According to a report published by Bloomberg Intelligence analysts Eric Balchunas and Tom Psarofagis, interest in pure factor funds has been muted as investors favor the watered-down exposure of traditional factor funds.
Investors “generally don’t like the high tracking error of purer funds or may lack the patience needed to truly capture a factor.” However, for investors who don’t mind deviating far from the market return or who have a longer time horizon, these pure factor ETFs may provide an opportunity to outperform, those analysts said.
In addition to PXMG, other pure growth funds like the Invesco Russell 2000 Pure Growth ETF (PXSG), targeting small-cap growth stocks, and the iShares Morningstar Large-Cap Growth ETF (JKE), targeting large-cap growth stocks, are among the top-performing factor ETFs of the year.
Another one on the list worth mentioning: the NuShares ESG Large-Cap Growth ETF (NULG). This fund selects stocks from the MSCI USA Growth Index that exhibit positive ESG characteristics. In other words, it is a “socially responsible” growth ETF. The portfolio is quite concentrated, with only 107 holdings.
Finally, while growth ETFs dominate the top-performing factor ETFs list, a few nongrowth factor funds managed to claw their way into the race.
The Hartford Multifactor Low Volatility U.S. Equity ETF (LVUS), the Oppenheimer Russell 1000 Quality Factor ETF (OQAL) and the Invesco S&P 500 Momentum ETF (SPMO) all made an appearance, with double-digit gains for the year.
None of these products are pure factor funds. LVUS holds low-volatility stocks, but aims to achieve marketlike returns.
OQAL targets large-cap stocks with strong quality characteristics based on return on assets, asset turnover, accruals and leverage. However, market cap still plays a role in determining each holding’s weight.
SPMO holds 100 of the stocks within the S&P 500 with the highest momentum, while also considering volatility and market capitalization.